Copyright 2018 Mitul Kotecha

Weekend developments in the trade war included China’s denial that they had reneged on any prior agreements, contrary to what the US administration has said as a rationale for ratcheting up tariffs on China. In fact, China’s vice-minister Liu He said that such changes (to the draft) were “natural”. He also said the remaining differences were “matters of principle”, which implies that China will not make concessions on such some key structural issues. This does not bode well for a quick agreement.

Meanwhile Trump’s economic advisor Larry Kudlow suggested that Trump and China’s President Xi could meet at the G20 meeting at the end of June. This offers a glimmer of hope but in reality such a meeting would achieve little without any agreement on substantive issues, which appears a long way off. Markets now await details from the US administration on tariffs on a further $325bn of Chinese exports to the US effectively covering all Chinese exports to the US.

China has promised retaliation and we could see them outline further tariffs on US exports in the next couple of days as well as the possible introduction of non-tariff barriers, making life harder for US companies in China. The bottom line is that any deal now seems far off while the risk of further escalation on both sides has risen. Global markets are increasingly taking fright as a result, especially emerging market assets.

There are no further negotiations scheduled between the US and China though Kudlow has said that China has invited Treasury Secretary Mnuchin and trade representative Lighthizer to Beijing for further talks. Given that Trump now appears to have a unified administration as well as many Republicans and Democrats behind him while China is digging its heels in this, don’t expect a resolution anytime soon.

China’s currency CNY is facing growing pressure as the US-China trade war escalates. The CNY CFETS index has weakened by around 1% in just over a week (ie CNY has depreciated relative to its trading partners) and is now at its weakest since 20 Feb 19. While not weaponising the currency, there’s every chance that China will manage CNY depreciation to help compensate Chinese exporters for the pressure faced from higher tariffs (as appeared to take place last summer). Expect more pain ahead.

Market attention returns to China this week, with markets there opening after Chinese New Year Holidays. US/China trade talks will dominate attention, with China’s Vice Premier Lie Hu meeting with US Treasury Secretary Mnuchin and Trade Representative Lighthizer in Beijing. Tariffs are scheduled to be raised from 10% to 25% on $200bn worth of Chinese exports to the US on March 2. If talks do not succeed it will act as another blow to the world economy.

The fact that US President Trump has said that he won’t meet China’s President Xi Jinping before March 1 suggests elevated risks of a no deal though both sides. Moreover, US officials will be wary of being seen to give in to China given the broad based domestic support for a strong stance against China, suggesting that they will maintain a tough approach. Even so, there is a huge incentive to arrive at a deal of sorts even if structural issues are left on the back burner.

At a time of slowing global growth and heightened trade tensions China’s January trade report will also be scrutinised this week. Market expectations look for a sizeable 10.3% y/y drop in imports and a 3.3% y/y fall in exports. The risks on imports in particular are skewed to the downside given the weakness in exports data from some of China’s trading partners in the region including South Korea, Taiwan, Singapore and Vietnam. A weak outcome will result in a further intensification of concerns about China’s economy.

Another focal point is the direction of China’s currency (CNY). As trade talks continue this week it is likely that China maintains a relatively stronger currency stance via stronger CNY fixings versus USD and stronger trade weighted (CFETS CNY nominal effective exchange rate). As it is the CFETS index is currently around its highest level in 7 months. Of course, if trade talks fail this could easily reverse as China retaliates to an increase in US tariffs.

A major focus for markets next weeks is the US/China trade talks in Washington. After the US reportedly turned down an offer of preparatory talks this week talks will begin on Monday, with China’s Vice Commerce Minister, Vice Finance Minister and central bank, PBoC governor.

It is unclear who on the US side they will meet, but the idea is to prepare the ground for the heavy weight talks between US Trade Representative Lighthizer, US Treasury Secretary Mnuchin and China’s top economic official Liu He, from Jan 30 to 31.

Both sides need a win on trade and markets are pinning their hopes on some form of a deal. The reality is that they are still very far apart on a number of issues. As highlighted by US commerce secretary Ross, a trade deal is “miles and miles” away.

The easier issues on the table are increased purchases of US goods by China, something that China has already said they will do, in order to help reduce the record Chinese trade surplus with the US. The tougher issues are more structural, including forced technology transfers, state subsidies, discrimination against foreign companies, regulations on intellectual property etc.

Not only is the US determined to gain China’s agreement on the above issues, but is also looking to find ways to ensure compliance monitoring. However, China does not believe that foreign companies are transferring technology to Chinese companies, while they have already offered measures to increase access to foreign investors. Overall, this means there is little room for negotiation.

In any case with just over a month left before the March 1 deadline that President Trump has set before he imposes increased tariffs of 25% on around half of Chinese exports to the US, there is little time to thrash out a deal on the key structural issues that would likely satisfy the US administration.

The likelihood is that negotiations will not be completed, especially on structural issues, leaving markets very little to be excited about. While both sides may leave the talks, claiming a degree of progress, this will not be sufficient to allay concerns. Risk assets will look vulnerable against this background.

As the end of the year approaches it would take a minor miracle of sorts to turn around a dismal performance for equity markets in December. The S&P 500 has fallen by just over 12% year to date, but this performance is somewhat better than that of equity markets elsewhere around the world. Meanwhile 10 year US Treasury yields have dropped by over 53 basis points from their high in early November.

A host of factors are weighing on markets including the US government shutdown, President Trump’s criticism of Fed policy, ongoing trade concerns, worries about a loss of US growth momentum, slowing Chinese growth, higher US rates, etc, etc. The fact that the Fed maintained its stance towards hiking rates and balance sheet contraction at the last FOMC meeting has also weighed on markets.

A statement from US Treasury Secretary Mnuchin attempting to reassure markets about liquidity conditions among US banks didn’t help matters, especially as liquidity concerns were among the least of market concerns. Drawing attention to liquidity may have only moved it higher up the list of focal points for markets.

The other major mover is oil prices, which have dropped even more sharply than other asset classes. Brent crude has dropped by over 40% since its high on 3 October 2018. This has helped to dampen inflationary expectations as well as helping large oil importers such as India. However, while part of the reason for its drop has been still robust supply, worries about global growth are also weighing on the outlook for oil.

But its not all bad news and markets should look at the silver lining on the dark clouds overhanging markets. The Fed has become somewhat more dovish in its rhetoric and its forecasts for further rate hikes. US growth data is not weak and there is still sufficient stimulus in the pipeline to keep the economy on a reasonably firm growth path in the next few months. Separately lower oil is a positive for global growth.

There are also constructive signs on the trade front, with both US and China appearing to show more willingness to arrive at a deal. In particular, China appears to be backing down on its technology advancement that as core to its “Made In China 2025” policy. This is something that it at the core of US administration hawks’ demands and any sign of appeasement on this front could bode well for an eventual deal.

Today marks the most interesting day of the data calendar this week. Central banks in the Eurozone (ECB), UK (BoE) and Turkey (CBRT) all announce policy decisions while US CPI (Aug) is released. The ECB and BoE meetings should be non events. The ECB is likely to confirm its €15 billion per month taper over Q4 18. The BoE monetary policy committee is likely have a unanimous vote for a hold.

The big move ought to come from Turkey. They will need to tighten to convince markets that the central bank it is free from political pressure and that it is ready to react to intensifying inflation pressures. A hike in the region of 300 basis points will be needed to convince markets. This would also provide some relief to other emerging markets.

The big news today is the offer of high level trade talks from US Treasury Secretary Mnuchin to meet with Liu He (China’s top economic official), ahead of the imposition of $200bn tariffs (that were supposedly going to be implemented at end Aug). This shows that the US administration is finally showing signs of cracking under pressure from businesses ahead of mid-term elections but I would take this with a heavy pinch of salt.

Mnuchin appears to be increasingly isolated in terms of trade policy within the US administration. Other members of the administration including Navarro, Lighthizer, and Bolton all hold a hard line against China. Last time Mnuchin was involved in such talks with China in May they were derailed by the hawks in the administration. So the talks could mark a turning point, but more likely they are a false dawn. That said it will provide some relief for markets today.

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